Marco Valdes, LL.M. student 2013/14, International Financial Law, King’s College London, (Italian qualified lawyer)
An essential issue in bankruptcy law, especially for European policy makers, is the question whether the law should remain firmly based on liquidation proceedings protecting primarily creditors’ rights (such as UK Insolvency law) or whether it should introduce more debtor-friendly provisions. As a matter of fact, many European governments are recently discussing the opportunity to amend their Bankruptcy Codes in order to encourage reorganisation instead of liquidation to decrease the mortality of viable firms in a post-financial crisis environment. The famous ‘‘Chapter 11’’ is the reorganisation system in the US Bankruptcy Code. It is considered particularly friendly to troubled companies, allowing them to continue to operate, receive new finance and giving them time to negotiate with their creditors, instead of being shut down and having its assets quickly sold off as practised in the liquidation process in the UK [1]. Even though the reorganisation model has been considered beneficial due to the track record throughout the US, where a number of leading companies such as United Airlines and Lehman Brothers have profited from it, some scholars tend to emphasise the shortcomings of it [2].
This article will provide a brief overview of the Chapter 11 system before the evaluation of three of its most innovative and controversial provisions: “automatic stay”, “debtor in possession” and “seniority of new finance” rule. The aim of this article is to examine these provisions in order to show that they could have, in most respects, more drawbacks than advantages in a non-US environment. It will conclude that, even though reorganisation should be preferred to liquidation if more value is captured, the US reorganisation model is not likely to be considered a suitable solution for European countries interested in preserving enterprise value and increasing business recovery. In order to be suitable for European economies it should be substantially amended to match its specific approaches towards highly indebted companies.
Overview of Chapter 11
The underlying principle behind reorganisation and Chapter 11 is that the going-concern value of a company tends to be more significant than the value of its assets if they were sold off individually [3]. Chapter 11 tends to favour the possible reorganisation and restructuring of the business to try to overcome the financial distress and avoid the closure of the company ending up in liquidation of all its remaining assets. Consequently, the aim of Chapter 11 is to set up a procedure which should be more economically efficient due to the fact that allows a distressed company to continue running by rescheduling part of its debts and giving control of the newly reorganised firm to consenting creditors instead of being dissolved. By doing so, in fact, creditors could extract more capital than they would in liquidation. As pointed out by some author automatic stay, debtor in possession and seniority of new finance are among the most important measures provided in the Chapter 11 of the US Bankruptcy Code in order to prevent company’s disruption [4].
Automatic stay
Some commentators describe an automatic stay as a freeze on proceedings or executions against the company and its going-concern assets (assets that might be necessary to keep the firm running when a firm is being reorganised) [5]. In other words, it represents a breathing space during which the company has been given a certain period of time to arrange a rescue plan with its creditors and shareholders for the restructuring of its debts and affairs. In a system where creditors are allowed to quickly sell the troubled firm’s assets when it files for a reorganisation scheme, the business could end up in premature liquidation [6]. Due to the uncertainty over the potential business recovery, even when the going-concern value could be higher than liquidation value, some creditors may prefer a more secure liquidation strategy. Accordingly, some scholars tend to admit that automatic stay could increase the rate of successful business recovery to a certain extent [7].
Despite the fact that some commentators tend to support some arguments in favour of automatic stay, the majority of them criticise the rule. They argue that creditors with short maturity claims are likely to be dependent on the immediate access to their funds in order to pay their own creditors [8]. To put it another way, if creditors’ claims are tied up for an extended period of time due to an automatic stay, they may find themselves unable to make payments to their own creditors. This is particularly the case of reorganisation proceedings in which a prolonged period of time is often necessary to arrange a restructuring plan with several classes of creditors. As a result, the recovery of one firm may result in the failure of some of its creditors [9]. On the other hand, if creditors do not have any chance to secure a quick repayment of their loans to bankrupt firms, they could subsequently increase the loan’s interest rate to compensate this potential risk [10]. Therefore, even though automatic stay could be successful in preserving going-concern value, if it continues more than an optimum time, it may cause financial distress to spread, bringing about a domino effect on the external stakeholders of the restructuring company. Looking at Europe, it seems that the provision, as presented in Chapter 11, could not be properly introduced due to the inclination, in European systems, in favour of creditors instead of debtors [11]. Creditors, especially in northern jurisdictions, are more reluctant to waive the terms of their credits and prefer to immediately seize the assets of the company to secure their repayment. These arguments imply that the rule, in order to be exported profitably into Europe, should be amended accordingly, taking into account the different approach of European creditors.
Debtor in possession
The second controversial aspect of the reorganisation proceeding of Chapter 11 is the debtor in possession rule. This provision allows the debtor to retain possession of the company and to continue to exercise the rights, power and duties typically associated to the board of directors and shareholders. Hence, the most relevant consequence of the rule is the fact that debtor’s management can stay in charge, without being displaced by an administrator appointed by the same creditors [12]. This opportunity could provide incentives for shareholders and directors to efficiently operate, make firm-specific investments and increase their expectation of residual return [13]. It is also suggested that debtor in possession may improve their incentives to propose a rescue plan at an early stage, while the business may still be viable, due to the fact that they will not be replaced by anyone else and will not lose their positions [14]. Additionally, in a managers-displacement system (such as in the UK trustee-appointment liquidation system) appointing outsiders without firm-specific knowledge could compromise irreversibly the value and viability of the company and may end up with improper liquidation [15].
One of the main arguments against debtor in possession is when the firm has become bankrupt predominantly due to the incapacity or negligence of the incumbent management. Accordingly, it can be clearly seen that the possibility for the debtor’s failing managers to stay in charge appears to be as another opportunity for the existing administration to destroy value [16]. Debtor in possession can also increase the cost of debt capital owing to the increased perception of risk for lenders of receiving repayments from a troubled firm which is conducted by the same failing management [17]. Therefore, allowing incumbent management to continue to stay in place, rather than forcing them out, seems to be more logically associated with a lower rate of successful business recovery. Furthermore, another relevant objection to debtor in possession is the fact that, in contrast to the US system, many European jurisdictions follow a managers-displacement system because of different attitudes and approaches adopted towards risk taking and entrepreneurship. European policy makers are inclined to punish failing managers when the risks go wrong and side with creditors who lose out [18]. As a result, in these systems, creditors feel very strongly that, when disaster strikes, the owner and its management should be prevented from continuing to manage financial resources and immediately replaced by a professional team appointed by the same creditors [19]. These arguments mean that the rule, a part from its possible negative implications, has proven to be difficult to export into Europe.
Seniority of new finance
In addition to automatic stay and debtor in possession, the possibility for distressed companies to raise new finance is another debatable issue of the US reorganisation model. Through this provision the debtor is entitled to receive, during the reorganisation process, bridge finance which has priority, in term of repayment, over pre-bankruptcy creditors in case of subsequent bankruptcy[20]. This rule aims to provide a safe environment for the availability of new finance, thus facilitating restructurings and increasing investment opportunities in distressed firms. In fact, providers of new finance require a level of certainty to incentivize their participation in a reorganisation process that could otherwise be considered a needless and dangerous delay for the execution of their rights [21]. This can be properly ensured only by preserving their rights and priorities over previous creditors inside of reorganisation process.
Looking at this provision from a different viewpoint, some authors argue convincingly that, as experienced in the US, new finance’s creditors have expanded their influence over any terms of the reorganisation process by means of covenants in financing agreements [22]. They can control the availability of necessary new finance to the company depending on the speed at which restructuring is handled. Thus, companies are generally compelled to sell off assets at an inappropriate early stage to meet repayment needs if restructuring conditions are not fully respected. Moreover, supporters of the analysed provision fail to take into account the lack of power and the realistic conflict of interests of the debtor compared to the all-mighty lenders such as distressed debt traders [23]. It seems that, in most respects, creditors consider themselves as the controllers of the debtor and they view debtor’s management to be merely a nuisance in their path to ultimate control over the company [24].
Finally, the difficulty to quickly obtain fresh finance is another controversial implication of the rule. This is basically due to the fact that bankrupt firms often have assets which are difficult to value. In the ordinary course of business, loans are usually available only after lenders spend a great deal of time reviewing the troubled firm’s assets. Additionally, loans are likely to involve unusually high interest rates to compensate for time spent in assets’ review and for the potential risk of lending to a firm with highly opaque assets [25]. Therefore, it can be considered that whoever buys up the debt of distressed companies has no real interest in business recovery and is generally unwilling to sacrifice a quick and safe recovery of their investments for the sake of a company’s rehabilitation [26].
Conclusion
From the discussion above it seems that the Chapter 11 process has been excessively characterised by the marginalization of debtor’s power, expansion of creditors’ control and short-term profit incentives instead of long-term values motivation. This article has explained that it is largely due to the intervention of several actors interested in gaining profitable returns from the reorganisation proceedings rather than in the business’ recovery. As a consequence, the objective of a successful preservation of going-concern value has been eclipsed in most cases [27]. In addition, it is generally recognised that the other most significant objection to the acquisition in Europe of the US model is the fact that it has been created for a different system with quite different objectives and approaches (as clearly shown for as regards automatic stay and debtor in possession).
There is undoubtedly some truth in the fact that reorganisation should be preferred to liquidation if more value is effectively realised in that way. However, reforming bankruptcy laws and making them similar to the US debtor-friendly system is not likely to be considered as the panacea for European countries interested in preserving enterprise value and increasing business recovery. They could benefit from the model only if they will be able to shape the provisions to match them with European creditors’ approaches and expectations but, at the same time, so as to prevent those actors from controlling excessively the process and increasing unfairly the cost of new finance.
[1] P. R. Wood, Principles of international insolvency, 2nd ed. rev. (2007) London: Sweet & Maxwell, pp.140
[2] V. Finch, Corporate Insolvency Law: perspectives and principles, 2nd ed. (2009) Cambridge: Cambridge University Press, pp. 356
[3] G. McCormack, Corporate Rescue Law in Singapore and the appropriateness of Chapter 11 of the US Bankruptcy Code as a model, (2008), 20 Singapore Academy of Law Journal, pp. 396
[4] S. H. Lee, Y. Yamakawa, M. W. Peng, J. B. Barney, How do bankruptcy laws affect entrepreneurship development around the world?, (2011), 26(5) Journal of Business Venturing, pp. 505
[5] A.R. Keay and P. Walton, Insolvency law: corporate and personal 2nd ed. (2008) Bristol: Jordan Publishing Ltd., pp. 97
[6] R. Goode, Principles of corporate insolvency law. St. ed. (2011) London: Sweet & Maxwell, pp.156
[7] K. Ayotte, D. A. Skeel Jr, Bankruptcy or bailouts, (2009), 35 The Journal of Corporation Law, pp. 469
[8] H. R. Miller, Chapter 11 in transition: from boom to bust and into the future, (2007), 81 American Bankruptcy Law Journal, pp. 375
[9] M. Brouwer, Reorganization in US and European bankruptcy law, (2006), 22(1) European Journal of Law and Economics, pp. 5
[10] A. Bris, I. Welch, N. Zhu, The costs of bankruptcy: Chapter 7 liquidation versus Chapter 11 reorganization, (2006), 61(3) The Journal of Finance, pp. 1253
[11] M. Succurro, Bankruptcy systems and economic performance across countries: some empirical evidence, (2012), 33(1), European Journal of Law and Economics, pp. 128
[12]See generally, R. Goode, Principles of corporate insolvency law. St. ed. (2011) London: Sweet & Maxwell; M. Succurro, Bankruptcy systems and economic performance across countries: some empirical evidence, (2012), 33(1), European Journal of Law and Economics, pp. 101
[13] V. Finch, Corporate Insolvency Law: perspectives and principles, 2nd ed. (2009) Cambridge: Cambridge University Press, pp. 250
[14] G. McCormack, Corporate Rescue Law in Singapore and the appropriateness of Chapter 11 of the US Bankruptcy Code as a model, (2008), 20 Singapore Academy of Law Journal, pp. 421
[15] R. J. Mokal, Corporate Insolvency law: Theory and application, (2005) Oxford: Oxford University Press, pp. 29
[16] See generally, K. Ayotte, D. A. Skeel Jr, Bankruptcy or bailouts, (2009), 35 The Journal of Corporation Law, pp. 469; M. Brouwer, Reorganization in US and European bankruptcy law, (2006), 22(1) European Journal of Law and Economics, pp. 5; H. R. Miller, Chapter 11 in transition: from boom to bust and into the future, (2007), 81 American Bankruptcy Law Journal, pp. 375
[17]See generally, P. R. Wood, Principles of international insolvency, 2nd ed. rev. (2007) London: Sweet & Maxwell
[18] S. H. Lee, Y. Yamakawa, M. W. Peng, J. B. Barney, How do bankruptcy laws affect entrepreneurship development around the world?, (2011), 26(5) Journal of Business Venturing, pp. 529
[19] E. Cirmizi, L. Klapper, M. Uttamchandani, The Challenges of Bankruptcy Reform, (2012), 27(2) The World Bank Research Observer, pp. 185
[20] V. Finch, Corporate Insolvency Law: perspectives and principles, 2nd ed. (2009) Cambridge: Cambridge University Press, pp. 231
[21] R. Goode, Principles of corporate insolvency law. St. ed. (2011) London: Sweet & Maxwell, pp. 179
[22] A.R. Keay, P. Walton, Insolvency law: corporate and personal. 2nd ed. (2008), Bristol: Jordan Publishing Ltd., pp. 215; A. Bris, I. Welch, N. Zhu, The costs of bankruptcy: Chapter 7 liquidation versus Chapter 11 reorganization, (2006), 61(3) The Journal of Finance, pp. 1272
[23] H. R. Miller, Chapter 11 in transition: from boom to bust and into the future, (2007), 81 American Bankruptcy Law Journal, pp. 399
[24] Even though, they are certainly viewed as responsible for putting their capital at risk in the first instance.
[25] E. Cirmizi, L. Klapper, M. Uttamchandani, The Challenges of Bankruptcy Reform, (2012), 27(2) The World Bank Research Observer, pp. 196
[26] Such is the culture of short-term gain as opposed to long-term efficiency for the company.
[27] M. Succurro, Bankruptcy systems and economic performance across countries: some empirical evidence, (2012), 33(1), European Journal of Law and Economics, pp. 119